Signs of economic slowdown emerge

As we head into the second quarter of 2023, the strength in the market this year so far has been notable. The S&P 500 is up about 6.0%, while the investment-grade bond market is up a healthy 4.5%. Keep in mind, though, that recent gains in stocks were largely driven by valuation expansion, as price-to-earnings ratios climbed higher. Meanwhile, earnings-growth expectations during this period have moved lower. Analyst forecasts now indicate that S&P 500 earnings growth will be less than 1.0% year-over-year, compared with a 5.0% estimate at the beginning of the year.

Despite these healthy market gains, the path forward in the near term may be challenging, especially as the economy weakens and potentially enters a mild recession. This past week we have seen signals of a pending slowdown emerging, including weakness in the labor market, manufacturing, and housing (see below). And this comes as the banking sector looks to potentially tighten bank-lending standards, adding incremental downward pressure on consumers and corporations.

Nonetheless, for long-term investors, there may be opportunities forming in the months ahead, particularly as markets start to look past the economic slowdown toward a recovery period.

Three signs of a slowing economy:

1. The labor market is showing signs of fatigue:?The labor market in the U.S. has been a source of strength in the economy, with an unemployment rate still near multidecade lows at 3.6%. However, last week we may have seen the first signs of cracks in the otherwise resilient job market. While the nonfarm jobs report was in-line with moderating expectations, the ADP private-payrolls report for the month of March fell well below the expected 250,000 increase, with 145,000 jobs added. In addition, the job openings data last week (JOLTS) - a more real-time indicator of labor resilience - showed that openings in February fell below 10 million for the first time in nearly two years, another signal that the labor market may be cooling. The silver lining here may be that wage growth, a key driver of services inflation, may also be moderating, which would support better core inflation trends.

2. Manufacturing and services activity continues to fall:?Last week data for U.S. manufacturing activity and services activity for the month of March came in well below expectations. The ISM manufacturing index, a gauge of manufacturing health, fell to a near three-year low to 46.3, below expectations of 47.5. Readings below 50 indicate a contraction in activity. Similarly, the ISM services index came in at 51.2, below expectations of 54.4, although still slightly in expansion territory. The manufacturing and services indexes are considered leading indicators of broader economic growth and are showing clear signs of slowing, which could indicate a slowdown ahead in the economy. However, perhaps the one bright spot in the ISM reports last week is that the prices-paid component, also a leading indicator of inflation, continued to move lower as well.

3.?The housing sector is softening:?Over the past couple of weeks we have seen housing data come in softer than expected. The housing and rental components of inflation have remained elevated, although the real-time data indicate a housing market that has started to soften. Last week's Case-Shiller national home price index saw moderating gains for seven straight months, coming in at 3.8% year-over-year, which has not been seen since the pre-pandemic period. Higher mortgage rates and cooling housing demand have weighed on the sector, which could also see further downside if mortgage-lending standards tighten.

Mild recession remains likely

In our view, the most likely scenario remains for a mild recession perhaps starting in mid-2023. The recent set of economic data seems to be confirming this view, and a softening labor market is often one of the later shoes to drop. For investors, equity markets will likely not ignore an economic slowdown, and near-term risks to the recent rally remain elevated. But we also believe that markets have captured some (or much) of the recession in the bear market over the past 15 months.

Perhaps the good news for balanced investors is that the bond markets this year have performed well, as yields have come down more recently and as investors seek more safe-haven assets. We would expect bonds to continue to play this diversification role in the year ahead, particularly during periods of equity-market volatility.

Opportunities may be forming in equities and bonds

It is also important to remember that the market cycle and economic cycle are distinct, and markets often can begin to recover months ahead of the economy. As markets start to look toward a recovery, we would expect healthy returns and more balanced leadership to emerge. In equities, while recent outperformance has come from defensive and growth sectors, we would expect areas like cyclical sectors (industrials, materials), small-cap stocks, and international equities to perform well as part of a "recovery playbook." And in bonds, we would look to complement positions in shorter-duration cash-like bonds (CDs, money-market funds) with longer-duration bonds, particularly in the investment-grade space. These bonds not only lock in better yields for longer, but also have the opportunity for price appreciation, especially if the Fed does pause and, over time, move interest rates lower. Thus, we would use any near-term volatility to diversify and add quality investments, according to your financial goals, as we see opportunities forming in both the stock and bond markets in the months ahead.

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